Is there a downside to refinancing?
Refinancing involves replacing your existing mortgage with a new one. This can lower your interest rate and monthly payment, and potentially save you thousands.
But while refinancing has its benefits, it isn’t the right choice for everyone. A refinance starts your loan over. And there are closing costs to consider, too.
Some people only focus on the new rate and payment. For refinancing to make sense, though, you have to look at the bigger picture and make sure you’ll save in the long run — not just month-to-month.
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Three things to know before you refinance
Besides getting a lower rate and monthly payment, other common reasons to refinance a mortgage can include switching loan programs or products, cashing out your home equity, or removing someone’s name from the loan.
But even if you have a good reason for refinancing, make sure you understand how it works. There are a few inherent drawbacks to refinancing that will impact your decision.
Hee’s what you should know.
1. Refinancing starts your loan over
Since refinancing replaces your current mortgage with a new one, it starts the loan over. And in many cases, borrowers reset the clock with another 30-year term.
Starting a fresh 30-year loan term can offer the biggest monthly savings. Yet this isn’t always the smartest move, depending on the number of years left on your existing mortgage.
If you’ve had the original loan for five, 10, or even 15 years, starting over with a new 30-year mortgage means you’ll pay interest on the home for a total of 35 to 45 years. That could increase the total amount of interest you pay over the life of the loan — even if your monthly payments go down.
Of course, this doesn’t always happen.
Some people receive a payoff date that’s similar to their original loan. For this to happen, you have to refinance into a shorter term.
Let’s say you’ve already had the original mortgage for five years. Instead of another 30-year mortgage, you can refinance into a 15- or 20-year mortgage. Or, if you’ve had the original loan for 20 years, you could refinance into 10-year mortgage.
Just note that shorter-term loans almost always have higher monthly payments. That’s because you have to repay the same loan amount in a shorter time frame.
But, as long as your new interest rate is low enough, you should see significant overall savings with a shorter loan term.
2. Refinancing costs money
Do you remember paying closing costs when you bought your house?
Unfortunately, refinancing also involves closing costs. These vary, but usually range between 2% and 5% of the loan amount. Closing costs are due at closing and can include:
- The lender’s origination fee
- A new home appraisal
- Recording fees
- Discount points
- Prepaid taxes and homeowners insurance
- And more
Generally speaking, refinancing only makes sense when your savings outweigh your closing costs. This is the ‘break-even point.’
For example, let’s say refinancing reduces your monthly payment by $300 a month and you paid $6,000 in closing costs. You must keep the new mortgage for at least 20 months to break even.
The good news is that you can often roll closing costs into your mortgage loan to avoid paying upfront — but only if you have enough equity.
Some lenders even offer no-closing-costs refinances, where you pay nothing (or very little) out-of-pocket.
The lender gives you a credit toward your fees, but it isn’t technically free. In exchange for a no-closing-cost refinance, you’ll likely pay a higher mortgage rate.
3. You could pay more in the long run
Yes, refinancing can provide immediate monthly savings by lowering your mortgage payment. But it doesn’t always offer long-term savings.
For instance, if you’re almost done paying off a 30-year loan and you start over with a new 30-year term, you’ll pay a lot more interest in the long run.
And your new interest rate and loan term aren’t the only factors influencing the overall cost. The amount of your new mortgage also plays a role.
Cash-out refinancing is another common reason for replacing a mortgage. This involves borrowing cash from your equity for home improvements, debt consolidation, and other purposes. In this case, your new mortgage balance will exceed what you currently owe.
Now, if you’re starting over with a new 30-year term and a lower rate, even with a bigger balance you might save monthly. But you’ll pay more in the long run — not only because you borrowed more, but also because you extended the overall loan term.
Before applying, use a refinance calculator to estimate your savings and costs.
You can avoid paying more by not touching your equity and keeping your new payoff date similar to the original one.
Sometimes, though, paying more is the lesser of two evils.
The bottom line is that refinancing can provide wiggle room in your budget and free up cash for other purposes. So if you’re having trouble paying your current mortgage payment or hitting other financial goals, the immediate savings might keep your head above water.
When is it a bad idea to refinance?
To sum things up, refinancing isn’t always a good idea — even if you can get a lower mortgage rate.
Here’s a look at when it might not make sense to refinance a mortgage loan.
- You won’t keep the mortgage long enough to break even
- You can’t get a lower interest rate
- You have issues with your credit score or credit history, and can’t qualify
- You’re close to paying off the original mortgage
- You’ll pay a lot more in the long run
- You can’t afford closing costs
- You’re cashing out your equity for the wrong reasons (vacation, shopping, etc.)
Remember that refinancing needs to have a net financial benefit. If a mortgage refinance won’t improve your financial situation in some way, then it’s probably not worth it.
When is it worth it to refinance?
Despite the inherent drawbacks — for instance, having to start your loan over — refinancing is often worth it. Especially at today’s near-record low interest rates, millions of homeowners could save on their housing costs.
Here are scenarios where it’s often a good idea to refinance.
- You’re able to lower your monthly mortgage payment
- Your new rate is 1% or more below your current rate
- Your credit profile has improved, and you can get a lower-rate loan
- You want to switch from an adjustable-rate mortgage to a fixed-rate mortgage
- You want to switch to a different loan program (for instance, from an FHA loan to a conventional loan with no PMI)
- You plan to keep the mortgage long enough to break even with your closing costs
- You can afford closing costs upfront
- You want to eliminate FHA or USDA mortgage insurance
- You want to decrease or increase the loan term
- You want to tap your home equity
- You’re removing a name from the mortgage loan
There are plenty of ways a mortgage refinance can benefit you. Aside from saving you money each month, a refinance could help you consolidate debt, pay for home improvements, pay off your home early, and more.
If you’re on the fence, talk to a mortgage advisor or loan officer who can help you explore your loan options and decide whether a refinance is worth it.
The bottom line: Should you refinance?
Refinancing can lower your mortgage rate, your monthly payment, and provide cash from your equity. Just make sure you consider the bigger financial picture before applying.
You need to consider the savings as well as the costs of refinancing — both short-term and long-term.
- How long will it take to break even?
- How long do you plan to live in the house?
- How long is the new mortgage term?
- Will you pay more or less interest overall?
As long as you crunch the numbers beforehand, refinancing can be a great decision. Many homeowners save thousands, or even tens of thousands, by refinancing into a lower rate.